Earnings season is here and not a moment too soon for those suffering from the summer time "blahs." Over the next few weeks corporate America will gussy up its numbers and put its best foot forward for Wall Street. The question is whether or not analysts and investors will like what they see enough to justify a stock market that’s already gone ahead and built in some solid earnings news.
In the attached clip John Butters of FactSet says expectations have come down some from where they were at the end of Q1 but there’s still plenty of optimism out there. “The earnings growth rate estimate right now stands at 4.9%. That is down from 6.8% at the start of the quarter but that’s one of the lowest declines in the growth rate we’ve seen in the last couple years.”
It’s worth unpacking that comment as it says a lot about the way the earnings game between analysts and corporations is played. For the companies the goal is to keep expectations low but positive then surprise to the upside. It’s more subtle than just sandbagging like crazy so mere survival looks like an accomplishment. Managers want analysts to be excited about the story, just not so much so that it’s impossible for the company to keep up with expectations.
The analysts are complicit in the game in the sense that it’s in their best interest to have stocks on their list of buys meet estimates and move higher. If a company rated “strong buy” does better than expectations clients remain happy. On the other hand missing estimates to the downside is always bad for everyone except the short sellers.
The unwritten “book” says that estimates always drift lower over the course of a quarter. Now that the rules are established it’s time to put it into the context of the great Wall Street parlor game called: “is the market over-valued?”
Butters says no but the assessment comes with a pretty big caveat. At 15.8x forward earnings the S&P 500 (^GSPC) is above it’s three and five year average but about in line with the average PE of the last 15 years. Of course, the only reason it looks relatively low is that analysts are looking for some explosive growth to kick in starting next quarter.
“For third quarter we were looking for 10.6% growth back at the start of the year that’s only down to about 9.3% today. Similarly for the fourth quarter we're looking for 12% growth at the start of the year and that’s only down to 10.3%.”
Butters notes that analysts have been wrong about the whole “growth picks up in the second half” theory twice in the last two years and the disappointment has done nothing to quell the enthusiasm for stocks. On a fundamental basis earnings will eventually have to justify valuation. At least in theory.
For now look less at trailing results and more at what the companies have to say about the current quarter and end of the year. If corporate America can’t strike just the right tone of cautious optimism that correction everyone has been looking for could be here sooner than even the bears think.
Merrill Lynch is not responsible for the editorial content of this program